How Prime Brokers Make Their Decisions

Prime broker services

What is Prime Brokerage?
When a package of services are offered by an investment bank or security firm to a hedge fund or other types of investors it is called prime brokerage. This usually happens when investors need to borrow securities or cash in order to invest in something that will guarantee a return. The prime broker is the bank that will lend the money and they usually do so by securing collateral from the investors, in case something falls through.

What is Included in the Service Package?

While each prime broker will have their own way of doing this, typically speaking, the following is included in the prime brokerage package:

  • Global custody which includes the clearing and custody as well as asset servicing.
  • Securities lending which requires the collateral.
  • Financing in order to leverage the client’s assets.
  • Portfolio reporting needed to manage the money.
  • Operational support where the prime brokers will offer themselves as the primary operations contact.

    Some other services that may or may not be included, depending on the type of deal made are:
  • Capital introduction which is where the prime broker introduces the client to other investors.
  • Office space if the primer broker leases real estate.
  • Risk management where the broker will provide risk assessment software for the client.
  • Consulting services which is usually only for start up hedge funds.
  • The services that are offered by the prime broker typically give a money manager the chance to be able to trade with several different brokerage houses, all the while keeping track of the hedge fund’s money in the form of cash and securities. This works because it allows the money manager to still be able to maintain relationships with other brokerage houses in order to receive initial public offerings, research, communication access and other things.

    How do Primer Brokers Make Money?
    While you would expect a prime broker to charge fees or interest on their services, they is not the case. Revenues are usually made from three places:

    1. Financing spread including stock loan
    2. Trading commissions and fees
    3. Debits, credits and short sales

    Because of this, clients that go through significant short selling or leverage are going to make more money for the prime broker than clients who do not. Fixed income clients will bring in less money for the broker but still are accepted because they usually present economic opportunity in foreign exchange or flow business areas.

    What are the Risks Involved?
    Because of how the whole process works, primer brokers take a risk in losing the value of the collateral that they are holding as security if it ends up decreasing below the loan value. There’s also a risk of the client not be able to pay back the deficit. And of course operational risk as well as their reputation is on the line.

    Risk is monitored usually within the client portfolios before the broker ever takes on their case. A few things are looked at with the portfolio:

    1. Liquidity
    2. Concentration
    3. Ownership
    4. Investment strategies
    5. Future goals
    6. Projected earnings

    The risks are usually put through a series of test scenarios which show the profit and loss that could happen in different situations. This will show the prime broker whether or not the client is worth the risk factor that is involved.

    There is a lot that goes into a decision to offer prime brokerage services as a hedge fund prime broker. It’s not a decision that can be taken lightly. There are many risks involved and even when a particular client shows a low risk factor there is always the chance that something could go wrong later on down the light and the client will have to be dumped from the roster. That client will still have options but the prime broker will have to eat the cost and the loss of things not working out the way they had anticipated. After a prime broker has been doing his or her job long enough, it gets easier to spot who will be a profitable client and who is going to fall by the wayside and making these decisions become a lot easier and actually lowers the risk factor. However, the start up for a prime broker can be very frustrating and costly if not done correctly. Getting advice and training from an experienced prime broker is always a better idea than trying to go at it alone.